Reasonable Compensation? John Edwards Tax Shelter Strikes Again

By Robyn Hagan Cain on February 23, 2012 | Last updated on March 21, 2019

If you follow tax law, you’ve probably heard of the John Edwards tax shelter. Former vice-presidential candidate Edwards saved a bundle in payroll taxes - around $600,000 - by forming an S-Corporation, paying himself a relatively modest salary through the S-Corp, and taking the rest of his pay in dividends.

This week, the Eighth Circuit Court of Appeals ruled that the IRS properly assessed an Iowa accountant — who implemented a similar tax shelter plan — for additional payroll taxes because the accountant had not paid himself “reasonable compensation.”

David Watson, a 25 percent owner of accounting firm Larson, Watson, Bartling, and Juffer, LLP (LWBJ), formed an S-Corporation, David E Watson PC (DEWPC) in 1996. Watson was the sole officer, shareholder, director, and employee of DEWPC. Watson transferred his interest in LWBJ to DEWPC; LWBJ paid DEWPC for Watson's services, and DEWPC paid Watson.

The amount DEWPC paid Watson, ($24,000 in salary, plus $175,470 and $203,651 as Sub S distributions in 2002 and 2003), raised a few eyebrows at the IRS. The IRS investigated DEWPC, determined that it had underpaid payroll taxes -- which are based on salary -- and assessed additional taxes and penalties against DEWPC for the period in question. DEWPC paid the amount, and then filed for a refund. When the IRS denied the refund claim, DEWPC sued the government.

At trial, the district court adopted the government expert's opinion that Watson's reasonable compensation should have been around $91,000 in wages, and denied the refund. The Eighth Circuit Court of Appeals affirmed the district court decision, finding that the district court did not err in requiring DEWPC to prove that it paid Watson reasonable compensation.

DEWPC claimed on appeal that the proof of reasonable compensation standard effectively imposed a minimum compensation requirement upon DEWPC, despite the fact that there is no statute, regulation, or rule requiring an employer to pay minimum compensation.

The Eighth Circuit Court of Appeals disagreed, noting that the courts give special scrutiny to salaries when the corporation is controlled by the employees who are being paid. Here, the district court did not err in decided that Watson's reasonable compensation -- based on education, expertise, and locale -- should have been around $91,000.

How can your clients avoid a similar ruling? Follow the Warren Buffet/John Edwards tax shelter example. While S-Corporation salaries don't have to reflect the full amount of compensation an employee receives, they should at least reflect reasonable compensation levels.

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